Financial instruments, particularly time certificates of deposit issued primarily by banks in the form of a contract between the depositor and the financial depository to typically pay a fixed interest rate for a fixed period of time at which redemption may occur. These instruments are typically not callable by the bank but redeemable by the depositor before maturity, subject to an early withdrawal penalty. In the U.S. these contracts are required by Truth in Savings Regulation DD to state at the time of account opening the penalty for early withdrawal. These penalties can not be revised by the depository prior to maturity.
Since their introduction, bank CDs have been marketed as relatively simple financial instruments. These CDs provide secure, fixed income to the depositors at interest rates that are more attractive than checking or savings. The depositor investing in CDs has traded liquidity for income. They have acknowledged that there is a “substantial penalty for early withdrawal” and have accepted that for the opportunity to get a higher yielding, FDIC insured, fixed rate investment. CD yields have not been regulated for several decades. Individual banks control the yields offered to depositors. With individual banks continually adjusting yields on each term differentials occur over time, between banks and within the offerings of individual banks.
CDs have historically provided banks with a stable source of funds at a known interest cost. This has allowed banks to lock-in interest margins on longer-term investments in loans and securities by utilizing CD funding. Banks have modeled their future earnings based on these contracts they have with depositors to pay a fixed rate of interest for a fixed period of time.
Truth in Savings Regulation DD specifies the rules for handling CD interest. The documentation of each CD will specify the selected compounding and crediting options and periods for that instrument. The frequency of compounding or crediting interest is not specified by regulation. CDs are either “Compounded CDs” or “CDs which are not compounded”.
“Compounded CDs” reinvest the interest periodically to the CD and grow the value of the CD to maturity. At any point in time the total current account value of the CD is equal to the principal and accrued interest balances. Periodically, the accrued interest will be credited to the principal balance and the new principal balance will earn interest at the interest rate of the CD.
“CDs which are not compounded” (non-compound CD) have interest paid to the account holder or credited to other accounts on a periodic basis. CDs which are not compounded have a principal value of the CD that remains constant throughout the life of the deposit. At any point in time the total current account value of the CD is equal to the principal and accrued interest balances. Periodically, the accrued interest will be paid to the account holder or credited to other accounts. Interest will accrue on the same principal balance throughout the life of the CDs which are not compounded.
The current net cash value of a CD at any time is calculated by subtracting any applicable early withdrawal penalty from the total current account value of the CD (total of principal and accrued interest balances).
History of Early Withdrawal
Early withdrawal of CDs has not been a problem for the banking industry. The depositors are well aware that there is a “substantial penalty for early withdrawal”. The banks have generally maintained the same penalty language in their contracts with depositors ever since they began offering CDs. CD customers were not interested in early withdrawal as interest rates declined since virtually all CDs on the books had higher interest rates than those being newly offered.
When providing interest rate information to customers, banks must, by current law, quote an Annual Percentage Yield (APY), a percentage rate that reflects the total amount of interest paid on an account; it is based on the interest rate and the frequency of compounding for a 365-day period. This is a very simple calculation.
The liquidation value of other fixed rate investment securities is determined by present valuing the interest rate over the term of the investment at the current market yield. The present value method of valuation is more complex and difficult to calculate than a simple interest forfeiture penalty traditionally found in CDs. Interest forfeiture is simple to understand and calculate without a computer and was considered to be appropriate for the bank CD customer when they were introduced. Not only was the forfeiture penalty disclosed, but banks were also required to warn depositors that there was a “substantial penalty for early withdrawal”. At this time, it is unlikely that many CD customers are aware that the penalties embedded in their investments are not economically substantial.
Interest Rate Environment
The present economic environment is a result of significant changes in interest rates over the last three decades. After the five-year constant maturing US Treasury index peaked in September 1981 at 15.93% according to FederalReserve.gov records, interest rates generally trended downward until this same index hit a low of 2.27% in June 2003. As of Apr. 15, 2006 the current five-year US Treasury yield is 4.97%.
With the elimination of deposit rate ceilings in the early 1980's, customers and banks observed that a 3-month early withdrawal penalty on 12% certificates was substantial. In the typical interest forfeiture approach the early withdrawal penalty is a function of the CD rate. The higher the certificate's rate of interest the higher the penalty. The 1982 CD at 12% with 3-month penalty would have had a 3% early withdrawal penalty. As of 2006, a 3% CD with the same penalty structure results in a penalty of only 0.75%. The impact of the penalty has fallen with the interest rate.
The penalty for early withdrawal is the deterrent to allowing depositors to take advantage of subsequent enhanced investment opportunities during the term of the instrument. The withdrawal penalty is usually stated as a number of days/months of lost interest. Customer inertia is a strong force to overcome, and interest penalties tend to be a major barrier in the mind of the purchaser.
When rates decline there is little reason for banks to be concerned about the significance of early withdrawal penalties. If however, interest rates go up economics allow depositors who hold CDs with insufficient early withdrawal penalties to improve their financial position without any risk to the depositor, but their banks will be at risk of losing significant deposits. Furthermore, the first banks which encourage early withdrawal and redemption of CDs despite their penalty, may cause a flood of withdrawals.
If the customer (depositor) takes early redemption, there are several negative consequences for the bank. First, the bank must cover the lost funds by going into other, more expensive spot markets to maintain its deposit levels. Second, the bank may try to sell a new CD but the interest cost to the bank will inherently be higher (otherwise there would not have been any redemption). Third, there are significant transaction costs to selling replacement CDs to those who have redeemed.
From the point of view of a competitive bank, getting CD holders from other banks to redeem their instruments and bring their deposits over to the new bank at maturity or earlier is highly attractive. The value of core retail deposits as reflected in acquisitions of bank deposits by other banks is material with many deposit premiums reported in the range of 4% to 7%. These premiums on retail deposits exist because CD owners have a predisposition to purchase another CD and other financial products with relatively less marketing effort by the bank once a relationship is established. The problem is essentially one of convincing the customer to redeem the old CD, choose the new bank, and make the purchase.
It is perhaps the convincing step which creates the greatest challenge. One problem of redeeming a CD and purchasing a new one is that the CDs are conventionally sold for specific time periods (such as 6 mo., 1 year, 2 years etc.). Traditionally, the purchaser of a new CD of similar term to maturity of the old one would necessarily increase the overall maturity date as measured from the start date of the original CD to the maturity date of the new CD.
This may be a serious impediment to closing the sale to reissue a CD. The buyer has to be convinced that the whole process of redemption and reissue is worth the bother, but if the date to maturity is extended, this may be just one step too far. A fatal impediment.
In other industries, such as the mobile (cell) phone industry, the extension of contracts has been a strong disincentive for customers to make a change in the contract no matter how desirable the new terms are.
Alternative CD Structures
Two types of CDs are available with regard to handling interest. CDs are either “Compounded CDs” or “CDs which are not compounded”.
“Compounded CDs” reinvest the interest periodically to the CD and grow the value of the CD to maturity. At any point in time the total current account value of the CD is equal to the principal and accrued interest balances. Periodically, the accrued interest will be credited to the principal balance and the new principal balance will earn interest at the interest rate of the CD. Depositors who want to keep a high proportion of their funds earning relatively high interest rates and do not need cashflow from their CDs generally take this option.
“CDs which are not compounded” (non-Compound CD) have interest paid to the account holder or credited to other accounts on a periodic basis. CDs which are not compounded have a principal value of the CD that remains constant throughout the life of the deposit. At any point in time the total current account value of the CD is equal to the principal and accrued interest balances. Periodically, the accrued interest will be paid to the account holder or credited to other accounts. Interest will accrue on the same principal balance throughout the life of the CDs which are not compounded. Depositors who would like or need cash for on-going financial needs generally take this option.
The current net cash value of a CD at any time is calculated by subtracting any applicable early withdrawal penalty from the total current account value of the CD (total of principal and accrued interest balances).
Each contact a depositor makes with their current bank to investigate or execute the re-issuance of their current CDs with another bank represents an opportunity for the current bank to interfere or distract the depositor. The most effective way to prepare for analysis of the re-issuance benefit is to gather data directly from the current bank. The most effective method to gather this data would be for the bank to receive acceptable authorization from the depositor to investigate the parameters of the existing deposit. This authorization would be similar to the payoff information request form used with real estate mortgage refinance today. This method would facilitate an efficient and accurate way to compile the necessary details of existing deposits such as maturity dates, total cash value at maturity, current net cash value after any applicable penalties. The bank could also inquire of the current APY offered on the same term of the deposit currently being considered for re-issuance to be used as a marketing differentiator in the event the Net Benefit To Transfer is insufficient to justify refinance.
The other contact that the bank facilitating the re-issuance would benefit from executing instead of relying on the depositor would be the actual withdrawal and transfer of funds. By receiving a signed consent and authorization to withdraw the CD early with penalty and transfer to a new CD at the re-issuing bank the bank can proceed to execute the transfer per the depositor's request. This eliminates another opportunity for the bank who issued the original CD to interfere, discourage or distract the depositor from making the re-issuance.